If you are an active trader of securities (stocks, ETFs, options, futures), it’s quite possible that you might qualify for trader tax status, enabling you to file a business tax return and deduct all of your trading related expenses. These deductions could end up saving you thousands of dollars in taxes each year but if you get it wrong, the IRS can revoke your trader status and assess penalties and interest on the tax difference. It’s important for traders to know exactly what the IRS looks at when determining trader status in order to qualify.
According to IRS Topic 429-Traders In Securities, the IRS looks at four pieces of criteria when determining trader tax status:
- Typical holding periods for securities bought and sold
- The frequency and dollar amount of your trades during the year
- The extent to which you pursue the activity to produce income for a livelihood
- The amount of time you devote to the activity
The problem with the above is that there are no specifics, only general requirements. It would be great if the IRS said you need X number of trades or X number of dollars, but they don’t. In fact, most of what we know about trader status, we have gathered from the cases that have gone to tax court over the years. Here are some guidelines gathered from past court cases for you to go from:
Typical Holding Periods
The majority of your trades should be short term (under one year) in nature. You don’t have to be a day trader to qualify, but if most of your gains are from positions you’ve held for a year or longer, you’ll most likely not qualify for trader status. There have been cases where trader status was revoked because 90 percent of the sells were long term.
Frequency and Dollar Amount
Your trading should be frequent and consistent. Again, you don’t need to be a day trader to qualify but you should have frequent buys and sells. You should also be consistent in your trading with little to no lapses in your activity. I’ve seen trader status get revoked when the trader did 85 percent of his trades in a three-month period and then very little the remainder of the year. The IRS revoked the status due to the frequency and consistency of his trading. The total dollar volume of your trading should be over $1,000,000 annually.
Extent You Pursue the Activity for a Livelihood
This requirement can be a little misleading as not all traders are profitable. What I can tell you here is to run your trading like a business. Keep good books and records. The more professional you make your trading business, the better in the eyes of the IRS. Just keep in mind that profitability has nothing to do with being able to claim trader status.
Amount of Time You Devote to the Activity
If you trade full time, you shouldn’t have a problem qualifying for this requirement. But what happens if you have a full-time job or another business and trade part time? My advice here is to keep track of the time you do spend trading and keep track of the time you spend researching and educating yourself. You don’t have to submit time cards to the IRS but in the event of audit, this can act as proof of the time you did spend.
Now that you know how to qualify for trader tax status, let’s review why you want to file as a business trader. My one word answer: deductions! If you file as a business trader, you are able to deduct all of your trading related expenses. If you file as an investor, you will miss out on thousands of dollars in tax savings. Here are some of the expenses you can deduct as a trader that you cannot deduct as an investor:
- Chat rooms and educational seminars/webinars
- Data feeds and software subscriptions
- Margin interest
- Home office
- Cable and internet
These items are just a few of the deductions you can take as a business trader. These expenses can easily put thousands of dollars back in your pocket each and every year. As I like to say, you have to pay taxes, you just don’t need to leave a tip! If you qualify for trader tax status, take advantage of the benefits by claiming the deductions you are entitled to take.